Mixed Up on The Right Asset Mix

ReshmaKapadia

No matter where you turn these days, financial advisers seem to agree that so-called alternative assets are just the thing for their clients' portfolios. According to one survey, more than 70 percent of investment advisers are recommending everything from real estate trusts to hedge fund–like investments, while another survey found that two-thirds of advisers believe alternative investments will be as important as traditional ones like stocks and bonds in the next five years. In all, mutual funds and exchange-traded funds that invest in alternative assets have almost tripled in the past three years, to $228 billion, according to consultancy Strategic Insight.

There's just one problem (okay, maybe two). When it comes to the question of how much of a client's portfolio should be devoted to alternative assets, advisers are all over the map. For example, Angela Thompson, a certified financial planner at Lincoln, R.I.–based Coastal Financial Planning, limits clients' alternatives allocation to 5 to 10 percent, in part because she has found only one fund whose track record she likes. But Mike Savage, who runs East Stroudsburg, Pa.–based Savage Financial Group, says alternatives can make up as much as 75 percent of a portfolio, depending on the client. ("I'm not a big fan of the stock or bond market," he says.)

The idea behind alternative investments is that they provide balance to the traditional portfolio of stocks, bonds and cash. Though alternative investments can be risky on their own, financial advisers say a basket of them can even out the risk and provide extra oomph to a portfolio. But for investors, the wide range of recommendations makes it difficult to figure out just what that mix should be. Indeed, an informal SmartMoney survey of 10 planners found that hardly any agreed on the same percentage.

One reason for all the confusion is that these products can be hard to comprehend, even for some of the pros. Almost half of the planners in a survey by Morningstar and Barron's said they hesitate to use alternatives because they don't understand them. Even the definition is the subject of debate. Some financial planners say investments like precious metals and real estate qualify as alternative investments, while others limit the category to more esoteric products like private equity and mutual funds that act like hedge funds. "The amount of assets that have moved into [alternatives] has far outstripped the amount of education," says Theodore Enders, a portfolio strategist at Goldman Sachs Asset Management who coauthored a white paper on alternatives, in part to address the confusion in the market.

SMOOTHING RETURNS

Alternative assets can be just about anything other than stocks, bonds or cash. Most planners use alternatives to even out the bumps in a portfolio, opting for investments that zig when stocks or bonds zag.

Commodities. Anything from oil futures to gold bullion can be found in this group. And some investors are turning to more-complex managed futures, which use financial instruments known as derivatives to benefit from price changes in commodities and other assets.

Hedged equity. Funds with fancy names like "long-short " or "market-neutral" can bet against stocks or use derivatives to offset the risks of particular stock investments or the market. The funds run the gamut, from those aimed at the risk-averse to ones for super-aggressive pros.

Everything else. Some planners pitch real estate or commercial leases on heavy equipment as alternative investments; others look for arbitrage funds that play the stock-price changes after a corporate merger is announced.

No one expects every portfolio to look alike, of course. Savage, for example, says investors who just want to reduce their overall risk might opt for the 25 to 30 percent range, but that someone trying to make money amid worries about inflation and sky-high government debt around the world might venture as high as 75 percent. Still, the growing hype over alternatives—and rising expectations among investors—worries some experts. Andrew Lo, chairman of AlphaSimplex Group, which runs hedge fund–like mutual funds, notes that some alternative mutual funds aren't as liquid as, say, a stock fund, and that could mean sharp losses in a crisis. He says he's also troubled by pitches that don't discuss the limits of alternative mutual funds. "Anyone expecting hedge fund–like returns is being sold a bill of goods," he says.

For investors willing to take on moderate risk, planners in theSmartMoney survey, on average, recommended devoting 18 percent of a portfolio to alternative assets and including a mix of commodity-related plays and investments that reduce the volatility of the portfolio through assets that don't move in the same direction as stocks or bonds. Some funds do the mixing for investors, such as the
or the
But both have limited track records as mutual funds, and they don't come cheap, with annual expenses of almost $300 for every $10,000 invested.

Want to assemble the pieces yourself? Morningstar alternatives analyst Nadia Papagiannis recommends picking a fund that has gone through at least one market cycle—a rally, a decline and a patch of bumpiness—to gauge its prospects. Financial advisers also recommend pairing alternatives like real estate or commodities with more broadly diversified alternative funds. The key, they say, is to remember that these funds will have periods of underperformance, ideally when other parts of the portfolio are going strong.

With so many new products hitting the market, advisers stress caution. "Start with the question of whether the fund came out of a good manager's mind or the marketing department," says Dan Roe, a principal at wealth-management firm Budros, Ruhlin & Roe in Columbus, Ohio. "At least two-thirds come from the latter."

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